Private Pension Plans – Advantages and Disadvantages

Readers Question: What are the advantages and disadvantages of leaving pension provision to the private sector? Could you please explain with the help of economic theory?

Advantages of Leaving Pensions to the Private Sector

Private Sector is thought to be more efficient. Private sector has profit motives to gain best return for investors, otherwise people will look elsewhere. This means in theory, private pension firms will take good care of the investments.

Governments don’t invest pension contributions. In theory, people pay taxes to make pension contributions, but, government rarely invest this money. Instead they pay pension payments out of current expenditure. This means with an ageing population, they will struggle to pay the pension commitments.

Avoid Higher Taxes. Private pensions enable the government to lower taxes. Arguably lower income tax may increase incentives to work. Lower corporation tax may increase incentives for business investment in the UK.

Ageing Population. A real problem the government faces is that the % of people over 65 is going to increase. This means an increase in the dependency ratio. Basically, there will be more people receiving pension compared to the number of people working and paying income tax. This is going to leave a black hole in government finances, relying on private pensions would avoid this problem.

Problems of Private Pensions

It will take time to change. The government has made a commitment to people in work they will receive a state pension. The government can’t turn round and tell people nearing retirement age that they are not going to honour these commitments. They could say to young people that they have to get a private pension, but, this means the government will still be paying state pensions for 20,30 or 40 years.

Private Schemes sometimes fail.The financial crisis highlights the fact that private finance firms can go bankrupt. If people invest in a private scheme, that scheme may go bankrupt and people will be left with nothing for retirement. This has already happened with some private pension schemes. Therefore, there is an expectation the government will step in and rescue those pensioners who have seen their private scheme fail. The point is you can’t rely on the free market to guarantee pensions.

Market Failure. You could say saving for a pension is a merit good. – People may be unable or unwilling to save. Therefore, when people reach retirement they will have insufficient funds and will be relatively poor. If there is no safety net, they could be absolutely poor. A state pension means everyone is forced to contribute to their pension by taxes.

Equity. The problem with relying on the private sector, is that it would lead to great inequality. Some well paid workers can afford to save to a private pension. But, low paid workers, with high living costs, may not be able to afford much pension contributions. Therefore, when they retire, they are left with nothing – increasing inequality within society.

Other issues – problems with means tested top up pensions reduce incentive to save.

Overall

The solution to the pension crisis is not to shift burden onto private sector. A better solution is to make people work longer – a reflection of extended life expectancy.